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Thursday, January 22, 2009

Analyzing Market-Linked GICs

A risk-averse friend was asking me about market-linked GICs as a possible investment. He believes this is a good time to own stocks, but wants protection against losing any money. Market-linked GICs seem to be a good fit, and so I decided to take a closer look.

The particular GIC my friend mentioned was Royal Bank’s 3-year GIC linked to the TSX 60 index (details explained here). The basic idea is that if the TSX 60 goes up after 3 years, you get a return, and if it goes down, you get your principal back with no return.

However, if the TSX 60 goes up over the 3 years, you don’t get the full return. For example, if the TSX 60 goes up 50%, your $100,000 GIC won’t grow to $150,000. If it worked this way, it would be the same as owning the TSX 60 stocks with a side promise to give you back your full $100,000 if the index goes down. Banks aren’t in the habit of giving out free lunches like this.

Enter the “participation factor,” or PF. The bank actually promises you a percentage of the TSX 60 return. So, if your PF is 60%, and the TSX 60 goes up 50%, your return on $100,000 is 60% of the $50,000 increase in the index, or $30,000. Your $100,000 would grow to $130,000.

A minor complication in all this is that the GIC return is not based on the TSX 60 value at the end of 3 years, but on the average value over the last year of the 3 years. This reduces volatility somewhat, but also reduces the expected return.

Unfortunately, I couldn’t find any information about what PF percentage is being offered by the Royal Bank right now. They say the PF is “set at the time the deposit is purchased based on our assessment of market conditions.” The PF is the critical factor in determining whether this GIC is a good investment or not.

Start by buying a CDIC-insured GIC that will be worth $100,000 when it comes due in 3 years. The best rate I was able to find was 4.1%. If we put $88,644 into this GIC, we’ll get $100,000 out after 3 years. This takes care of the guaranteed protection of principal. Now we get to play with the left over $11,356 from our original $100,000 to invest.

We’ll put the remaining money into stock options on the TSX 60. As I write this, the TSX 60 is at 1287. We’d like to buy options struck at 1287, but the Montreal exchange only offers call options expiring in March of 2011 on the TSX 60 (ticker: VIU) stuck at 1200 and 1400. This is a little sooner than Royal Bank’s market-linked GIC which bases return on the average price over the final year (Jan. to Dec. 2011). We’ll buy the options struck at 1400. So, we’ll only get the return on the TSX 60 above 1400, instead of 1287.

As I write this, VIU options struck at 1400 have a bid of $210 and an ask of $260. That’s a huge spread, but let’s assume that we can’t do any better than the ask price. Our $11,356 would buy 43 contracts priced at $260, with $176 left over. Part of this would be eaten up by the trading commission.

With the TSX 60 at 1287, these 43 contracts represent the upside on just over $55,000 worth of the TSX 60 index. This is an effective participation factor of 55% of the original $100,000. However, we only get the upside above 1400, and our options expire a little sooner than Royal Bank’s market-linked GIC. So, if the Royal bank is offering a PF less than about 50%, we think we can do better.

I’m not actually a big fan of principal protection. I think the cost of this protection is too high. But for investors who want this protection, it’s important to evaluate whether your market-linked GIC is a good deal or not. If anyone can do better than I have at building a market-linked GIC equivalent to maximize the effective PF, I’d be pleased to hear about it.

Money Minder: Thanks for the pointer. This author has several books. The closest I found to a 10-year old book was Money Logic by Moshe Arye Milevsky and Michael Posner, published in 2000. Does this sound like the right one?

Your right on MJ. PPN's sell because people think they will recieve the entire return if the linked asset appreciates which is not the case. What's worse, is that PPN can be link to much more complicated types of investments like hedgefunds and leveraging schemes.

I had previously left a comment in which I had mixed up the option contract numbers and Michael fixed it, but it's a good segue in that a former colleague of mine did the same thing, with real money for his own account. Thought he was buying 10 put option contracts, but entered in 1000 in the terminal (thinking he wanted underlying exposure to 1000 shares). By the time he realized what he had done, he was down $20,000.

I am personally interested in making my own Market-Link GICs. Thanks for explaining to me the participation rate.

The one you created has a 55% market participation rate and I think that is really great. I am trying to figure out how 3yr CIBC Stock Market Advantage GIC has a 65% participation rate. 65% participation rate is after CIBC making money off you and mutual fund salesperson making another set of commissions.

I know options have become very expensive recently. Maybe that is the reason why making your own market linked GIC seems to have a very low market participation rate.

Using options make you loose the potential gains from dividends. I am thinking that during times of high dividends, one should own equities. During times of low dividends, one should make one's own Market Linked GICs. What do you think?

EconStudent: My bias is toward owning equities all the time with money you won't need for 3 to 5 years. I agree that the apparent high price of options dampens the participation rate of self-constructed market-linked GICs. Your thoughts on dividends made me think about a different way to construct your own market-linked GIC that captures the dividends -- look for Monday's post for details.

The income earned in the Market Linked GICs is considered interest income too, right? So even if the "thing" you're linked to may have a combination of dividends and capital gains, you don't get the cheaper tax cost do you?